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OLIGOPOLY

The term ‘Oligopoly’ is coined from two Greek words ‘Oligoi meaning ‘a few’ and
‘pollein means ‘to sell’.

It occurs when an industry is made up of a few firms producing either an identical

product or differentiated product.

In simple words, “Oligopoly is a situation in which there are so few sellers that
each of them is conscious of the results upon the price of the supply which he
individually places upon the market”-The number of sellers is greater than one,
yet not big enough to render negligible the influence of any one upon the market
price.

Definition:

The concept of oligopoly can be defined as under:

“Oligopoly is that situation in which a firm bases its markets policy in part on the
expected behaviour of a few close rivals.” – J. Stigier

“An oligopoly is a market of only a few sellers, offering either homogeneous or

differentiated products. There are so few sellers that they recognize their mutual
dependence.” – PC. Dooley

“Oligopoly is a market structure characterized by a small number of firms and a

great deal of interdependence.” -Mansfield

“An oligopoly is a market situation in which each of a small number of

interdependent, competing producer’s influences but does not control the
market.” – Grinols

“Oligopoly is a market situation in which number of firms in an industry is so small

that each must consider the reaction of rivals in formulating its price policy.” –
McConnel
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FEATURES

Oligopoly is a market situation in which there are only a few sellers of a

commodity. Under this, each seller can influence its price-output policy.

It is because the number of sellers is not very large and each seller controls a big
portion of total supply.

Price-output policy of a firm does affect the rivals. The price which is fixed under
oligopoly without product differentiation is indeterminate. In case of
differentiated products, monopoly agreements are even less possible.

1. Monopoly Power:

There is a clement of monopoly power in oligopoly. Since there are only a few
firms and each firm have a large share of the market. In its share of the market,
it controls the price and output. Thus, an oligopoly has some monopoly power.

2. Interdependence of Firms:

Under perfect competition there are so many small firms and no single firm is
strong enough to influence price or output. So, the firms do not care about the
actions and reactions of other firms. Under monopoly, the question of
interdependence of firms does not arise because there is one single firm in the
market.

Under oligopoly, there are only a few firms, each producing a homogeneous or
slightly differentiated product. Since the number of firms is small, each firm
enjoys a large share of the market and has a significant influence on the price and
output decisions. Thus, there is interdependence of firms. No firm can ignore the
actions and reactions of rival firms under oligopoly.

3. Conflicting Attitude of Firms:

Under oligopoly, two types of conflicting attitudes are found in the firms. On the
one hand, firms realize the disadvantages of mutual competition and desire to
combine to maximize their joint profits. This tendency leads to the formation of
collusion. On the other hand, the desire to maximize one’s individual profit may
lead to conflict and antagonism, the firms come into clash with one another on
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the question of distribution of profits and allocation of markets. Thus, there is an

existence of two opposing attitudes among the firms.

4. Few firms. In this market, only few sellers are found:

For example, the market for automobiles in India exhibits oligopolistic structure
as there are only few producers of automobiles. If there are only two firms, it is
called ‘duopoly’.

5. Nature of product:

If the firm’s product homogeneous product, it becomes pure oligopoly. The firms
with product differentiation constitute impure oligopoly.

6. Interdependence among firms:

In oligopoly market, each firm treats the other as its rival firm. It is for this reason
that each firm while determining price of its product, takes into account the
reaction of the other firms to its own action.

7. Large number of consumers:

In this market, there are large numbers of consumers to demand the product.

8. Indeterminate demand:

The demand curve under oligopoly is indeterminate because any step taken by
his rivals may change the demand curve.

KINKED DEMAND CURVE

Under oligopoly, prices and output are indeterminate. Moreover, organizations

are mutually dependent on each other in setting the pricing policy.

Therefore, economists found it extremely difficult to propound any specific

theory for price and output determination under oligopoly.
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In the words of Maurice, “there is no theory of oligopoly in the sense that there
is a theory of perfect competition or of monopoly. There is no unique general
solution but merely many different behavioural models, each of which reaches a
different solution.” Thus, the economists have developed various analytical
models based on different behavioural assumptions for determining price and
output under oligopoly.

Figure-1 shows different oligopoly models:

Let us discuss different oligopoly models (as shown in Figure-1).

1. Sweezy’s Kinked Demand Curve Model:

The kinked demand curve of oligopoly was developed by Paul M. Sweezy in 1939.
Instead of laying emphasis on price-output determination, the model explains the
behaviour of oligopolistic organizations. The model advocates that the behaviour
of oligopolistic organizations remain stable when the price and output are
determined.

This implies that an oligopolistic market is characterized by a certain degree of

price rigidity or stability, especially when there is a change in prices in downward
direction. For example, if an organization under oligopoly reduces price of
products, the competitor organizations would also follow it and neutralize the
expected gain from the price reduction.

On the other hand, if the organization increases the price, the competitor
organizations would also cut down their prices. In such a case, the organization
that has raised its prices would lose some part of its market share.

The kinked demand curve model seeks to explain the reason of price rigidity
under oligopolistic market situations. Therefore, to understand the kinked
demand curve model, it is important to note the reactions of rival organizations
on the price changes made by respective oligopolistic organizations.
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There can be two possible reactions of rival organizations when there are
changes in the price of a particular oligopolistic organization. The rival
organizations would either follow price cuts, but not price hikes or they may not
follow changes in prices at all.

A kinked demand curve represents the behavior pattern of oligopolistic

organizations in which rival organizations lower down the prices to secure their
market share, but restrict an increase in the prices.

Following are the assumption of a kinked demand curve:

i. Assumes that if one oligopolistic organization reduces the prices, then other
organizations would also cut their prices

ii. Assumes that if one oligopolistic organization increases the prices, then other
organizations would not follow increase in prices

iii. Assumes that there is always a prevailing price

A kinked demand curve model is explained with the help of Figure-2:

The slope of a kinked demand curve differs in different conditions, such as price
increase and price decrease. In this model, every organization faces two demand
curves. In case of high prices, an oligopolistic organization faces highly elastic
demand curve, which is dd’ in Figure-2.

On the other hand, in case of low prices, the oligopolistic organization faces
inelastic demand curve, which is DD’ (Figure-2). Suppose the prevailing price of a
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product is PQ, as shown in Figure-2. If one of the oligopolistic organizations makes

changes in its prices, then there can be three reactions of rival organizations.

Firstly, when the oligopolistic organization would increase its prices, its demand
curve would shift to dd’ from DD’. In such a case, consumers would switch to
rivals, which would lead to fall in the sales of the oligopolistic organization. In
addition, the dP portion of dd’ would be more elastic, which lies above the
prevailing price.

On the other hand, if price falls, the rivals would also reduce their prices, thus,
the sales of the oligopolistic organization would be less. In such a case, the
demand curve faced by the oligopolistic organization is PD’, which lies below the
prevailing price.

Secondly, rival organizations will not react with respect to changes in the price of
the oligopolistic organization. In such a case, the oligopolistic organization would
face DD’ demand curve.

Thirdly, the rival organizations may follow price cut, but not price hike. If the
oligopolistic organization increases the price and rivals do not follow it, then
consumers may switch to rivals. Thus, the rivals would gain control over the
market. Thus, the oligopolistic organization would be forced from dP demand
curve to DP demand curve, so that it can prevent losing its customers.

This would result in producing the kinked demand curve. On the other hand, if
the oligopolistic organization reduces the price, the rival organizations would also
reduce prices for securing their customers. Here, the relevant demand curve is
Pd’. The two parts of the demand curve are DP and Pd’, which is DPd’ with a kink
at point P.

Let us draw the MR curve of the oligopolistic organization. The MR curve would
take the discontinuous shape, which is DXYC, where DX and YC correspond
directly to DP and Pd’ segments of the kinked demand curve. The equilibrium
point is attained when MR = MC. In Figure-2, the MC curve intersects MR at point
Y where at output OQ.
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At point Y, the organization would achieve maximum profit. Now, if cost

increases, the MC curve would move upwards to MC. In such a case, the
oligopolistic organization cannot increase the prices. This is because if the
organization would increase the prices, the rival organizations would decrease
their prices and gain the market share. Moreover, the profits would remain same
between point X and Y. Thus, there is no motivation for increasing or decreasing
prices. Therefore, price and output would remain stable.

However, kinked demand curve model is criticized by various economists.

Some of the major points of criticism are as follows:

i. Lays emphasis on price rigidity, but does not explain price itself.

ii. Assumes that rival organizations only follow price decrease, which does not
hold true empirically.

iii. Ignores non-price competition among organizations. Non-price competition

can be in terms of product differentiation, advertising, and other tools used by
organizations to promote their sales.

iv. Ignores the application of price leadership and cartels, which account for
larger share of the oligopolistic market.

PRICE LEADERSHIP

Price Leadership under Oligopoly: Types, Price-Output Determination and

Feedback!

In certain situations, organizations under oligopoly are not involved in collusion.

There are a number of oligopolistic organizations in the market, but one of them
is dominant organization, which is called price leader.

Price leadership takes place when there is only one dominant organization in the
industry, which sets the price and others follow it.
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Sometimes, an agreement may be developed among organizations to assign a

leadership role to one of them. The dominant organization is treated as price
leader because of various reasons, such as large size of the organization, large
economies of scale, and advanced technology. According to the agreement,
there is no formal restriction that other organizations should follow the price set
by the leading organization. However, sometimes agreement is formal in nature.

Price leadership is assumed to stabilize the price and maintain price discipline.

This also helps in attaining effective price leadership, which works under the
following conditions:

i. When the number of organizations is small

ii. Entry to the industry is restricted

iii. Products are homogeneous

iv. Demand is inelastic or less elastic

v. Organizations have similar cost curves

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price discipline. There
are three major types of price leadership, which are present in industries over a
passage of time.

These three types of price leadership are explained as follows:

i. Dominant Price Leadership:

Refers to a type of leadership in which only one organization dominates the entire
industry. Under dominant price leadership, other organizations in the industry
cannot influence prices. The dominant organization uses its power of monopoly
to maximize its profits and other organizations have to adjust their output with
the set price.
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The interests of other organizations are ignored by the dominant organization.

Therefore, dominant price leadership is sometimes termed-as partial monopoly.
Price leadership by the leading organization is most commonly seen in the
industry.

ii. Barometric Price Leadership:

Refers to a leadership in which one organization declares the change in prices at

first and assumes that other organizations would accept it. The organization does
not dominate others and need not to be the leader in the industry. Such type of
organization is known as barometer.

This barometric organization only initiates a reaction to changing market

situation, which other organizations may follow it if they find the decision in their
interest. On the contrary, the leading organization has to be accurate while
forecasting demand and cost conditions, so that the suggested price is accepted
by other organizations.

Barometric price leadership takes place due to the following reasons:

a. Lack of capacity and desire of organizations to estimate appropriate supply and

demand conditions. This influences organizations to follow price changes made
by the barometric organization, which has a proven ability to make correct
forecasts.

b. Rivalry among the organizations may make a leader, which can be

unacceptable by other organizations. Thus, most of the organizations prefer
barometric price leadership.

iii. Aggressive Price Leadership:

Implies a leadership in which one organization establishes its supremacy by

threatening the organizations to follow its leadership. In other words, a dominant
organization establishes leadership by following aggressive price policies and
forces other/organizations to follow the prices set by it.
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CHARACTERISTICS

ADVANTAGES

Advantage of Price Leadership:

(i) One most important advantage of price leadership is that by this method the
firms opt out of the uncertainty surrounding pricing decisions in oligopoly. There
is interdependence between the firm’s own behaviour and the behaviour of its
rivals. Firms choose a parallel price rather than resort to undercutting each other.
This process facilitates development of new products and improvement in
quality.

(ii) Price leadership eliminates the possibility of a price-war.

(iii) Price leadership involves a mutual understanding between the oligopoly firms
and is the most convenient strategy for oligopoly firms to stay and grow together.

or

Profitability

Where the price leader sets high product prices and competitors implement the
price changes, then the company and the other players will enjoy higher profits
as long as consumer demand remains steady. Also, where the competitors
replicate the price leader’s actions, it ensures that the price leader does not lose
the significant market share it enjoys to the competitors.

Reduces price wars

Where the market comprises companies of the same size, there are likely to be
price wars as each competitor tries to increase its market share. However, when
one company establishes itself as the market leader, there are likely to be fewer
price wars as the small competitors try to safeguard their market share. Instead,
they will adjust the prices of their products and services to correspond to the
prices set by the price leader.

Better quality products

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When a company establishes itself as a price leader, it increases its annual

revenues, some of which are used to design new products and improve product
quality. Customers want to pay a premium price for a premium product, and the
company can only deliver it when its activities are profitable. Profits earned from
its current products can be re-invested in research and development to find new
ideas that will help the company deliver value to its customers.